Passing the buck on inflation

Bottom Line 

Nominal retail inflation soared to a fresh, larger-than-expected 40-year high of 8.6% year-over-year (y/y) in May (up from 8.3% in April and 8.5% in March), dashing investor hopes that the Consumer Price Index (CPI) had peaked earlier this year. Likewise, forecasts that the Federal Reserve would pause hiking interest rates come September have been shelved, as the bond market is now pricing in three more half-point increases in the fed funds rate at their upcoming policy-setting meetings on June 15, July 27 and September 21. There is even worrisome speculation that the Fed may increase the size of their next hike to 75 basis points. 

In addition, the preliminary Michigan Consumer Sentiment Index for June plunged this morning to a new 44-year record low of 50.2, due to rampant inflation worries. Initial weekly jobless claims spiked yesterday by almost 38% over the past three months to a five-month high of 229,000 claims, so the labor market is starting to slow. With the personal savings rate plummeting from 26.6% in March 2021 to a 14-year low of 4.4% in April 2022, consumers at the margin are less able to afford these higher prices, which are reflecting surging labor, commodity and transportation costs for businesses. As a result, stagflation pressures could intensify, which is why we reduced our GDP estimates last month to 2.4% for this year and to 1.5% in 2023.  

Financial markets getting hit After a dead-cat bounce of nearly 10% from May 20 to June 2, the S&P 500 has corrected sharply by more than 6% this week, as equity investors now realize that the damaging combination of slower economic growth, higher inflation and tighter Fed policy is upon us. At a minimum, we still expect stocks to re-test mid-May’s 3,810 low, and perhaps push lower to 3,500 over the summer. Benchmark 10-year Treasury yields have round-tripped, falling from 3.15% to 2.70% during May and rebounding back to 3.15% over the past two weeks. 

Broad-based inflation Nominal inflation increased by a much larger-than-expected 1.0% month-over-month (m/m) in May, versus a 0.3% m/m gain in April. Energy prices soared by nearly 35% y/y in May, reversing April’s decline, as gasoline prices at the pump leapt by almost 49%.  Transportation prices rose by more than 19%, commodities by 13%, food and beverages by almost 10% and housing by nearly 7%. As the economy has re-opened post-Covid and people are traveling again, airline fares surged by almost 38% y/y in May.     

What’s to blame for this spike in inflation and how do we fix it? Exiting the pandemic recession, we’ve had too much money chasing too few goods, as supply-chain disruptions were exacerbated by monetary and fiscal policy developments. While the initial implementation of the Fed’s aggressive monetary policy was completely appropriate, it remained overly accommodative for far too long, as the Fed should have started to tighten this time last year. In addition, while generous fiscal policies helped to extricate the economy from the pandemic recession in its early stages, the continuation of those policies was like throwing gasoline on a fire.  

Fed behind the curve The Fed started to taper its $120 billion monthly bond-buying program last November and ended the program this past March. The Fed will begin to passively shrink its bloated $9 trillion balance sheet on June 15, at a pace of $47.5 billion in each of June, July, and August--$30 billion in Treasuries and $17.5 billion in mortgage-backed securities (MBS.)  Starting in September, the Fed will accelerate its pace of quantitative tightening to $95 billion monthly ($60 billion in Treasuries and $35 billion in MBS). Their longer-term plan is to cut their balance sheet by a third over the next three years, which equates to an additional effective tightening of about 25 basis points annually.   

The Fed ended its zero interest-rate policy by raising the fed funds rate by a quarter point at its March policy-setting meeting for the first time since 2018. They aggressively shifted to half-point increases (for the first time in 22 years) in May. After today’s CPI spike, we now expect at least three more half-point hikes through September, two more quarter-point hikes through year end and four more quarter-point rate hikes over the course of 2023. In conjunction with quantitative tightening, the fed funds rate could be pushing 4.0% by the end of 2023.  

So why didn’t the Fed start this tightening process a year ago when inflation began to surge?  With his possible renomination for a second term as Fed Chair hanging in the balance, Jerome Powell publicly deemed inflation “transitory,” and he appeared reluctant to change policy before the “procedural base effects” rolled off. It wasn’t until early December, after his renomination, that Chair Powell (and Treasury Secretary Janet Yellen) finally threw in the towel on “transitory” inflation.   

“The Buck Stops Here” President Harry S. Truman kept a sign with this phrase on his desk in the Oval Office, signifying that he accepted the ultimate responsibility for making the tough decisions. In contrast, President Biden assigned to the Fed the primary responsibility to combat inflation.  

We welcomed the $2.2 trillion Coronavirus Aid, Relief & Economic Security (CARES) Act in March 2020, which provided desperately needed support for the economy. But the subsequent $900 billion Consolidated Appropriations Act in December 2020 was unnecessary, as the economy was already out of recession and had rebounded strongly: 

• The National Bureau of Economic Research in July 2021 dated the end of the recession in April 2020, marking the two month recession as the shortest, but deepest in history. 
• GDP rebounded by 33.8% in the third quarter of 2020, the single best quarter in history after it plunged in the second quarter of 2020 by 31.2% (quarter-on-quarter, annualized), marking the worst quarter in U.S. economic history.
• GDP (on a chained-dollar basis) peaked at $19.3 trillion in the fourth quarter of 2019. It  plunged to a trough of $17.3 trillion in the second quarter of 2020, and it rebounded to $19.4 trillion in the second quarter of 2021. GDP has continued to rise to $19.7 trillion in the first quarter of 2022.

The key provisions of the $1.9 trillion American Rescue Plan (signed into law in March 2021) were economically unnecessary and inflationary, sharply increasing energy, food, housing, and labor costs. Nominal CPI has soared from 2.6% y/y in March 2021 to 8.6% in May 2022.